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New tax rules are a game changer for family estate planning


As a result, parents with highly appreciated retirement accounts may want to rethink bequests.

Many parents, seeking to be completely fair, bequeath assets in equal amounts to each of their children. For sibling heirs who inherit their parents’ estates collectively, this usually means liquidating assets to settle the estate.

Relatively new tax rules on inherited tax-deferred retirement accounts—IRAs and 401(k)s—complicate this kind of estate planning considerably, especially for high-net-worth physicians bequeathing large, highly appreciated accounts. The new rules are forcing even the most doting of parents to reconsider what’s fair and restructure bequests accordingly.

These rules are part of the Secure Act of 2019, a sweeping package of legislation whose ramifications are taking a while to sink in regarding estate planning. Under previous rules, heirs receiving tax-deferred retirement accounts had their entire lives to draw them down completely, as required by the IRS; that’s why these accounts acquired the moniker, “stretch” IRAs. By stretching out these distributions, heirs could minimize the tax impact in any one year and avoid bracket creep.

The Secure Act changes all this by requiring heirs to draw down these accounts down within 10 years of the benefactor’s death-- in most cases, but there are exceptions for certain categories of beneficiaries. (For more information, see IRS Publication 590-B, “Distributions from Individual Retirement Arrangements,” available on www.irs.gov).

Depending on the size of the retirement account, the income of the recipient and their tax scenario, inheriting the account may result not only in higher income tax in any one year, but also higher rates of taxation from bracket creep, or even what could be called bracket zoom—going up multiple brackets.

As a result, for the tax benefit of the entire family, parents with highly appreciated retirement accounts may want to re-think bequests. Here are some considerations regarding strategies for minimizing tax impacts:

The practice of leaving everything to the children for them to divide may now be less than optimal. Regarding large, accounts, the 10-year distribution limit might mean that even part of one could bring a huge tax burden to one or more heirs. A preferable alternative might be for such heirs to instead receive other items, such as real estate. The stepped-up basis of real property might have far less impactful tax consequences.

Consider leaving taxable accounts, like IRAs, to kids who are doing less well than their siblings, and then evening out the dollar-value of bequests using other assets. If you have three children and one has a relatively low income, that child might be the best candidate for receiving the entire retirement account. The other two could receive more tax-friendly assets.

One solution might be to leave all the children a Roth IRA collectively. Like regular IRAs and 401(k) accounts, Roths must also be distributed within 10 years. But, as these accounts are funded with post-tax money, withdrawals don’t incur tax or add to taxable incomes. As converting tax-deferred accounts into Roths involves paying the tax due on these distributions, conversions can involve considerable expense. Whether this is a good option depends on how the numbers work out for benefactors and heirs.

For wealthy benefactors, Roth conversions are usually a partial solution at best. IRS rules prohibit Roth contributions from individuals with annual earned incomes of $144,000 and up and, for married couples filing jointly, of $214,000 and up. So it’s hard for high earners to accumulate a substantial portion of their wealth in a Roth. Though some high earners may have started Roth IRAs when they were earning far less, and these accounts may have appreciated substantially over the years, they aren’t likely to hold much in the way of total assets, proportionately, of wealthy individuals.

Converting a regular IRA to a Roth might be a solution. Though the income limits for contributions also apply to conversions, this strategy still might be feasible, depending on your circumstances and the timing involved. That’s because it’s all about the tax year of the conversion.

You might be able to convert in the tax year after retiring. Under this strategy, the idea is to limit income in the year of conversion, perhaps by delaying Social Security benefits (which must be claimed by age 70), and/or by delaying other retirement income streams (such as pensions) and withdrawals from taxable investment accounts.

Of course, the tax you’d pay on a Roth conversion reduces the value of your estate, meaning that heirs would receive less. However, if the tax impact on heirs of receiving a highly appreciated retirement account would be severe enough, the cost of converting might be well worth it.

If your estate is large enough, paying the tax on an after-retirement conversion might be the lesser of two evils. The federal lifetime gift and estate tax exemption is currently $12.06 million per person, and for married couples filing jointly, twice that amount). Estates below this size trigger no estate tax for heirs. This exemption is scheduled to decline to $5 million (adjusted for inflation) at the end of 2025, but it might be extended, or one considerably higher might be set, before then.

If your estate’s total value would likely be close to the current limit—or to the scheduled, lower limit, if you expect that to become reality—doing a Roth conversion might be advisable because paying the tax on the conversion would reduce the size of your estate, potentially lowering beneath or keeping it under the gift- and estate-tax exemption amount, thus sparing your heirs the burden of estate tax. The cost of conversion might pale in comparison with the cost of estate tax. And converting would also spare heirs the burden of paying taxes on distributions over the allowable 10-year period.

These considerations and strategies apply to parents bequeathing retirement accounts directly to non-spousal heirs, the category of grown children. This may or may not be more tax-efficient than leaving everything to surviving spouses.

Regarding spouses, the best option for benefactors sometimes is to execute a spousal transfer of the tax-deferred account. When spouses become an IRA or 401(k) account holder this way, they can withdraw gains tax-free after five years. (When they make withdrawals, they must be at least 59½ to avoid penalty.) After that, the account is treated as though the receiving spouse were the original owner. There are no required minimum distributions (RMDs)—required amounts that must be drawn down annually beginning at age 72, and spouses can keep these accounts for life and leave them to their heirs.

The new rules of the Secure Act make bequests of tax-deferred retirement accounts more complicated and potentially more expensive. But if appropriate strategic planning steps are taken with the new rules in mind, it’s possible to lessen or avoid additional tax liability.

David Robinson, a CERTIFIED FINANCIAL PLANNER™ professional, is a director and senior wealth advisor with Mariner Wealth Advisors, an SEC Registered Investment Adviser. David works in the firm’s Phoenix office. He provides wealth planning services and creates custom financial plans to help clients grow and protect wealth, manage taxes and identify insurance solutions. He also prepares clients for retirement and manages estate plans. Prior to joining Mariner Wealth Advisors, he was CEO of Robinson, Tigue and Sponcil, an SEC-registered advisory firm in Phoenix.

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